Nathan Bell

Not Jim Chanos, founder of Kynikos Associates. He predicted their demise and profited from them, just as he did when he bet against Macquarie Bank Group in 2007.

Chanos started Kynikos (Greek for "cynic") to profit from a practice known as short selling, where investors profit when the stock price of a company falls.

This isn't the same as profiting when stock prices go up. When we buy a stock, especially if it pays a reasonable dividend, we can hang on as long as we need to for the market to recognise the stock's real value.

Shorting is different. Like buying, it requires lots of research, but it has to be married with precise timing. It's a rare and highly specialised skill.

The fact that Chanos has earned returns well in excess of the indices and his other hedge fund counterparts by short selling is a testament to his skill.

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You may never short a stock in your life, but if you understand what Chanos is looking for in a good short, then you'll know what shares to avoid. He offers three basic pointers:

1. Avoid debt-fuelled asset bubbles.

Questionable accounting is the foundation to everything Chanos shorts. But you don't need to be an accountant to pick up things that should set alarm bells ringing. Pay attention to the footnotes of the annual reports and compare these to the company's competitors, closely examining different assumptions that different managements use. Then ask, “Which manager is more conservative?”

Chanos finds the accounting for companies that serially conduct mergers to be extremely murky.

When debt is added to the mix, it often signals that all is not well – the company may have resorted to chasing new streams of revenue just to maintain the illusion of earnings growth.

Tyco was an American conglomerate that found a clever but legal accounting gimmick to hide money-losing divisions when acquiring other companies using leverage.

Many Australian investors were lured by ABC Learning's “aggregation model”, but a glance at its 2005 annual report footnotes should have raised questions.

ABC's largest assets were “childcare licences”, but a footnote revealed that their valuation was left entirely up to ABC's management and details were never properly disclosed.

Astute investors picked this up three years before the stock fell into administration.

2. Avoid industry obsolescence

Some of Chanos' most profitable shorts have been Eastman Kodak, Blockbuster and, more recently, Hewlett-Packard.

These companies appeared cheap, often selling for single-digit price-earnings ratios.

But all operated in sunset industries, victims of technological change that drove their earnings down year after year.

By paying 10 times earnings for a declining business today, investors may actually be paying 20 times near future earnings because profits can quickly halve.

Some of Australia's great and good, including Gina Rinehart, Mark Carnegie and John Singleton have moved into the “old media” sector by grabbing fistfuls of “quantitatively cheap” stocks in the Ten Network and Fairfax. Qantas has also featured in plays.

It's quite possible these investments will suffer the same fate.

Betting on an ailing business is like backing a bleeding horse; the pay-off is high but the odds are stacked heavily against you.

3. Avoid the “one-trick pony”

These are companies that rely on one factor for their earnings, perhaps a single “fad product”, government protections via easily repealed legislation or an isolated discovery, as in the case of many mining and biopharmaceutical companies.

Chanos' most successful shorts have included companies that manufacture Cabbage Patch dolls, George Foreman Grills and Martha Stewart (the products, not the person). There was a huge fad element to their success.

A different but local example is salary-packaging company McMillan Shakespeare.

It relies on a single tax loophole for public health sector employees to earn a major part of its revenue. Selling on a price to earnings ratio of 20 and more than 40 times operating cash flows, it would take one swipe of the legislative pen for those profits to disappear.

Sensible, profitable investing is as much about avoiding the losers as it is betting on winners. The Jim Chanos approach will help you avoid the losers.

As for picking the winners, well, that's a different game altogether.

This article contains general investment advice only (under AFSL 282288).

Nathan Bell is research director at Intelligent Investor. BusinessDay readers can enjoy a free trial offer. For more Intelligent Investor articles click here.